September 21st, 2020
How the Pensions Lifetime Allowance works and what it means for your clients
Any client who makes substantial contributions to their pension, or has held their pension for many years, could face issues with the Lifetime Allowance (LTA).
Introduced in 2006, the LTA put a cap on lifetime pension savings after which a tax charge would become payable.
As the graph below shows, the LTA started at £1.5 million, increased to £1.8 million and then reduced to £1 million with the government promising to increase this on an annual basis based on the Consumer Prices Index (CPI). In the 2020/21 tax year, the level is £1,073,100.
Since 2016, when the Lifetime Allowance was reduced, more and more people have been caught by the limit. The latest figures available from HMRC show that the LTA tax take has increased by more than 2,000% in the last ten years, to more than £102 million.
And, as the LTA now only increases in line with CPI, more clients will ‘sleepwalk’ into having an LTA issue as, historically, pension funds and salaries have grown faster than CPI.
Here’s your basic introduction to the Lifetime Allowance, and what we can do to help.
How is the LTA calculated?
Calculating the LTA is quite simple if your client is in a Defined Contribution scheme as it’s simply the pension investment fund value.
Defined Benefit (Final Salary) schemes have caused more of an issue. The ‘equivalent’ fund size is the annual pension payable multiplied by 20, plus any lump sum that is payable in addition.
If a client has a mixture of pension types, they need to add them all up to work out their LTA position.
When does the LTA apply?
Whenever a client takes pension benefits, a percentage of their LTA is used. This is called a Benefit Crystallisation Event (BCE). According to HMRC, there are 13 such BCEs ranging from taking a lump sum to a client’s death.
Not drawing benefits from a pension won’t mean that you can escape the LTA test. This is because there is a final calculation at age 75, when everything has to be declared. Both ‘crystallised’ and ‘uncrystallised’ pensions are added together for the test.
Even if a client dies before taking benefits, then that’s another specified BCE, which means they will still be tested post-mortem.
Taxation if over the LTA
If, at the time of testing, a client exceeds the LTA then the options are:
- Take the excess as a lump sum before 75, less a 55% Lifetime Allowance charge
- Retain the excess in the pension fund before or after age 75, less a 25% Lifetime Allowance charge. In this instance, when drawing a pension income, the income will be taxed at (probably) 40%, which would make the total tax charge broadly equivalent to 55%.
Protecting the LTA limit
In some cases, ‘protection’ is available for clients who have higher fund sizes than the current LTA.
The idea of this is to ensure that those who have funded for larger pensions (and possibly tax-free cash) prior to the introduction of the LTA rules are not penalised. Some people will still be eligible to claim LTA protection now depending on their circumstances.
As you might imagine, the rules are complicated.
We can help clients facing an LTA issue
As we mentioned earlier, the LTA tax charge is affecting an increasing number of people. The issue can raise its head not just at retirement, but also in cases such as a divorce where there are significant pension assets to split.
Of course, it is important to remember that pension contributions can still represent value to a client, even considering an LTA tax charge. The net return after tax may still be attractive – for example, if the contributions were from an employer with no personal contributions.
LTA legislation is a complex area and family lawyers should be sensitive to cases where LTA issues may be present. To make matters confusing, some of these issues will not be immediately apparent at first glance. We may need to ask additional questions regarding pension contribution histories, whether LTA Protection Certificate(s) exist and past BCE events.
Get in touch
We’re here to advise you and your clients on all aspects of retirement planning. If you have clients that would benefit from advice, or you’re interested in how you can work more closely with us, please get in touch. Email firstname.lastname@example.org or call 01562 829 222.